Chapter 19 - The logic of individual choice: The foundation of supply and demand. After reading this chapter, you should be able to: Discuss the principle of diminishing marginal utility and the principle of rational choice; explain the relationship between marginal utility and price when a consumer is maximizing total utility; summarize how the principle of rational choice accounts for the laws of demand and supply;...
Introduction: Thinking Like an Economist CHAPTER 2 CHAPTER 19 12 The Logic of Individual Choice: The Foundation of Supply and Demand The theory of economics must begin with a correct theory of consumption — Stanley Jevons McGrawHill/Irwin Copyright © 2013 by The McGrawHill Companies, Inc. All rights reserved The Logic of Individual Choice: The Foundation of Supply and Demand 19 Chapter Goals Ø Ø Ø Ø Discuss the principle of diminishing marginal utility and the principle of rational choice Explain the relationship between marginal utility and price when a consumer is maximizing total utility Summarize how the principle of rational choice accounts for the laws of demand and supply Name three assumptions of the theory of choice and discuss why they may not reflect reality 192 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Rational Choice Theory Ø Ø According to traditional economists, our behavior is motivated by rational self interest According to this theory, two things determine what people do: • • Utility, which is the pleasure people get from doing or consuming something The price of doing or consuming that something 193 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Total Utility and Marginal Utility Utility = Satisfaction Ø Ø Total utility is the total satisfaction one gets from consuming a product Marginal utility is the satisfaction you get from the consumption of one additional unit of the product above and beyond what you have consumed up to that point 194 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Diminishing Marginal Utility Ø The principle of diminishing marginal utility states that after some point, the marginal utility received from each additional unit of a good decreases with each additional unit consumed • • • As additional units are consumed, marginal utility decreases, but total utility continues to increase When total utility is at a maximum, marginal utility is zero Beyond this point, total utility decreases and marginal utility is negative 195 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Rational Choice and Marginal Utility Ø Ø Ø Rational individuals want as much satisfaction as they can get from their available resources Any choice that does not give you as many units of utility as possible for the same amount of money is an irrational choice According to the basic principle of rational choice, people spend their money on those goods that give them the most marginal utility per dollar 196 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Maximizing Utility and Equilibrium Ø • The utility maximizing rule states that when the ratios of the marginal utility to price of the two goods are equal, you are maximizing utility If MU X PX MU Y , you are maximizing utility PY 197 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Extending the Principle of Rational Choice Ø Utility is maximized when: • • MU X PX MU Y PY MU Z PZ The cost per additional unit of utility is equal for all goods and the consumer is as well off as is possible A person’s choice of how much to work is made simultaneously with the person’s decision of how much to consume 198 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Rational Choice and the Law of Demand Ø When the price of a good goes up, the marginal utility per dollar (MU/$) from it goes down, and we consume less of it and its marginal utility increases • Ø Quantity demanded falls as price rises When the price of a good decreases, the MU/$ increases, and we consume more of it and its marginal utility decreases • Quantity demanded increases as price falls 199 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Rational Choice and the Law of Demand Income and substitution effects Ø Ø Ø The inverse relationship between price and quantity demanded is due to the income and substitution effects The income effect is the reduction in quantity demanded when price increases because the price increase makes one poorer The substitution effect is the reduction in quantity demanded when price increases because you substitute another good for the more expensive one 1910 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Rational Choice and the Law of Supply Ø According to the principle of rational choice, if there is diminishing marginal utility… • • and the price of supplying something goes up, you supply more of that good and the price of supplying something goes down, you supply less of that good 1911 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Opportunity Cost Ø Ø Ø Ø Opportunity cost is the benefit forgone of the nextbest alternative In the context of utility, it is the marginal utility per dollar you forgo from consuming the next-best alternative According to the principle of rational choice, to maximize utility, choose goods until the opportunity cost of all alternatives are equal If the MUX/PX > MUY/PY, the opportunity cost of not consuming good x is greater than the opportunity cost of not consuming good Y so we consume X 1912 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Applying the Theory of Choice to the Real World Decision making is costless Ø Ø The costs of deciding among hundreds of possible choices may lead us to some things that seem irrational Most people may use bounded rationality which is rationality based on rules of thumb • • “You get what you pay for” is the implication that high price equals high quality “Follow the leader” leads to focal point equilibria in which a set of goods is consumed because they have become focal points to which people have gravitated 1913 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Applying the Theory of Choice to the Real World Tastes are given Ø Ø Ø Ø Implicit in the theory of rational choice is that utility functions are given, not shaped by society “Given tastes” is the assumption on which an economic analysis is conducted Tastes are often significantly influenced by society Conspicuous consumption is the consumption of goods not for one’s direct pleasure, but to show off to others 1914 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Applying the Theory of Choice to the Real World Individuals maximize utility Ø Ø Ø Ø People may not behave rationally in practice Behavioral economics have found through experiments that many people not maximize utility The experiment of the ultimatum game shows that people care about fairness as well as income Experiments also reveal a bias where individuals’ actions are influenced by the current situation, even when that reasonably does not seem to be very important to the decision 1915 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Chapter Summary Ø Ø Ø Total utility is the satisfaction obtained from consuming a product; Marginal utility is the satisfaction obtained from consuming one additional unit of a product The principle of diminishing marginal utility states that after some point, the marginal utility of consuming more of the good will fall Utility is maximized and equilibrium reached when: MU X PX Ø MU Y PY Unless MUX/PX= MUY/PY, an individual can rearrange his or her consumption to increase total utility 1916 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Chapter Summary Ø Ø Ø Ø The laws of demand and supply can be derived from the principle of rational choice If the price of a good increases, you will decrease consumption of that good so that its marginal utility increases If your wage rises, the marginal utility of the goods you can buy with your wage will rise and you will work more to maximize utility Behavioral economists argue that the assumptions of the theory of choice, costless decision making, given tastes, and utility maximization may not always apply when people make decisions 1917 ... reasonably does not seem to be very important to the decision 19 15 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Chapter Summary Ø Ø Ø Total utility is the satisfaction... rearrange his or her consumption to increase total utility 19 16 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Chapter Summary Ø Ø Ø Ø The laws of demand and supply can... consuming something The price of doing or consuming that something 19 3 The Logic of Individual Choice: The Foundation of Supply and Demand 19 Total Utility and Marginal Utility Utility = Satisfaction